Topic 9 & 10 Revision Questions Flashcards
Briefly explain how a company determines its target or optimal capital structure.
The target (or optimal) capital structure refers to the optimal mix of debt, preference shares and ordinary equity with which the company plans to use to finance its investment opportunities. The target (or optimal) capital structure for a company is determined by the capital structure that minimizes the overall cost of capital for the company, thereby maximizing the market value of the company, which in turn maximizes the overall wealth of its ordinary shareholders.
Business risk
Business risk is the risk or uncertainty associated with a company’s business operations, ignoring any fixed financing effects. Specifically, business risk refers to the relative variability of a company’s operating income that arise from changes to its cost structure and/or changes to its operating environment (e.g. industry competition). Since changes in operating income affect a company’s profitability and/or financial viability, both preference shareholders and ordinary shareholders are affected by business risk.
Financial risk
Financial risk is the additional risk or uncertainty, over and above the business risk, that is borne by a company’s ordinary shareholders which arises from the manner in which the company’s assets are financed. Specifically, financial risk refers to the additional variability in earnings available to ordinary shareholders that arise from the company’s financing decisions and includes the additional risk of bankruptcy from the use of financial leverage. Since changes in the earnings available to ordinary shareholders affect a company’s ability to make dividend payments to ordinary shareholders, only ordinary shareholders are affected by financial risk.
the three (3) general theories of capital structures that are used to explain corporate decisions relating to the capital structure of a business.
Trade off theory
Signalling theory
Pecking order theory
Trade-off Theory:
Trade-off Theory argues that there is a ‘trade-off’ between the tax benefit versus the bankruptcy-related cost associated with debt financing. Specifically, Trade-off Theory argues that, since interest payments are a tax-deductible expense, the government effectively subsidises part of the cost of debt capital, resulting in more operating income flowing through to shareholders. However, as the company uses greater amounts of debt, the risk of bankruptcy also increases, which results in the company having to pay higher interest rates. Therefore, from the Trade-off Theory’s perspective, the optimal capital structure for a company is the point at which the tax benefit from additional debt exactly offsets the increase in bankruptcy-related cost, thus resulting in the minimum overall cost of capital for the company.
Signalling theory
On the other hand, Signalling Theory argues that, owing to asymmetric information between company managers and external investors, the company management’s choice between debt financing versus equity financing is viewed by market investors as a signal about the company management’s perception of the future financial prospects for the company. Since external investors expect that companies with bright financial prospects will prefer debt financing over equity financing, the decision to use debt financing is viewed as a positive signal by market investors that company managers perceive the company’s future financial prospects to be bright. Conversely, since external investors expect that only companies with poor financial prospects will prefer equity financing, the decision to use equity financing is viewed as a negative signal by market investors that company managers perceive the company’s future financial prospects to be poor. Accordingly, the implication of Signalling Theory is that companies should always maintain a reserve borrowing capacity by using less debt than the ‘optimum debt level’ suggested by Trade-off Theory in order to ensure that further debt capital can be obtained later if required.
Pecking order theory
Since external investors know that company managers will attempt to issue new equity when they perceive the company’s shares as overpriced, market investors will necessarily discount the price that they are willing to pay for the company’s shares by underpricing the company’s shares. Pecking Order Theory argues that, to avoid this underpricing, company managers prefer to finance investment opportunities using retained earnings, followed by debt financing, and will only choose equity financing as last resort.
The relative advantages of debt financing compared to equity financing are as follows:
Maintaining ownership and control:
Tax deductions:
Lower interest rates:
Maintaining ownership and control:
Unlike equity financing, debt financing does not involve selling claims to ownership of the business to market investors. As such, by using debt financing, the owner is able to maintain ownership and control over the business.
Tax deductions:
Unlike the dividend payments associated with equity financing, the interest payments associated with debt financing are tax deductible, with the government effectively subsidising part of the cost of debt capital.
Lower interest rates:
Since debtholders usually demand lower returns (in the form of lower interest rates) than ordinary shareholders, debt financing is typically cheaper than equity financing.
The relative disadvantages of debt financing compared to equity financing are as follows:
Repayment obligations:
Risk of bankruptcy:
Need for collateral:
Repayment obligations:
With debt financing, there is a need to make periodic fixed repayments to the debt holder on a regular basis. As such, the business must ensure that it can generate sufficient cash flows to meet the repayments when they fall due or face becoming bankrupt. There is, however, no such repayment obligation with equity financing.
Risk of bankruptcy:
Debt financing increases the risk of bankruptcy for the business. Furthermore, in the event the business becomes bankrupt, the debt holder has priority in claiming the assets of the business before ordinary shareholders. There is, however, no such risk of bankruptcy with equity financing.
Need for collateral:
With debt financing, the business is usually required to pledge some of its assets as collateral in order to protect the debt holder against possible default. There is, however, no such requirement for collateral with equity financing.
Capital Structure
The combination of debt and equity used to finance a company’s assets.
Total Assets
Total Liabilities (debt financing) + Total Equity (equity financing).
Operating leverage
Operating Leverage refers to the presence of fixed operating costs (as opposed to variable operating costs) within a company’s cost structure.
A company with relatively high fixed operating costs will experience greater variability in operating income if sales were to change.
Fixed-cost sources of finance:
Debt
Preference shares
Variable-cost sources of finance:
Ordinary shares
Explain why bond prices have an inverse relationship with interest rate movements.
Since the coupon rate of a bond is fixed until maturity, the price of a bond will vary according to interest rate movements in the market. If the coupon rate is the same as the market interest rate, then the bond will sell for its par value (i.e. a ‘par bond’).
However, if the coupon rate is greater than the market interest rate, then there will be increased demand for the bond which causes an increase in the market price of the bond, resulting in the bond selling for a premium (i.e. a ‘premium bond’).
Conversely, if the coupon rate is less than the market interest rate, then there will be decreased demand for the bond which causes a decrease in the market price of the bond, resulting in the bond selling for a discount (i.e. a ‘discount bond’).
In this way, bond prices are said to have an inverse relationship with interest rate movements, with bonds prices increasing when market interest rates decline and bond prices decreasing when market interest rates rise.
Explain why preference shares are considered as a form of hybrid security.
Preference shares are considered as a form of ‘hybrid security’ because preference shares possess some features that are similar to bonds and some features that are similar to ordinary shares.
On the one hand, preference shares are similar to bonds in that fixed dividends must be paid to preference shareholders before dividends can be paid to ordinary shareholders. On the other hand, preference shares are similar to ordinary shares in that preference shares have no fixed maturity date and there is no obligation for companies to pay dividends to preference shareholders. In other words, companies can omit dividend payments to preference shareholders without the fear of defaulting and pushing the company into bankruptcy.
Explain why a company’s ordinary shareholders are often referred to as its residual claimants.
As ‘residual claimants’, ordinary shareholders have residual claims to any earnings that remain only after: (i) interest payments are made to debt holders; (ii) corporate tax is paid to the government; and (iii) dividends are paid to preference shareholders.
Additionally, in the event a company becomes bankrupt, ordinary shareholders have residual claims to any assets that remain only after: (i) all claims by debt holders are settled; and (ii) all claims by preference shareholders are settled.
the dividend payment
process:
(a) Declaration date;
(b) Cum dividend;
(c) Ex-dividend date;
(d) Record date;
(e) Payment date.
(a) Declaration date;
Declaration date is the date on which the company’s board of directors publicly announces the amount and the specifics (such as the payment date) of the next dividend payment.
(b) Cum dividend;
Cum dividend refers to the situation where the legal right to the next dividend payment accompanies a share. When investors purchase shares that are cum dividend, they are entitled to receive the next dividend payment on the payment date. Conversely, when shareholders sell shares that are cum dividend, they will not be entitled to receive the next dividend payment on the payment date.
(c) Ex-dividend date;
Ex-dividend date is the date on which the legal right to the next dividend payment no longer accompanies a share. In Australia, the ex-dividend date occurs 4 business days prior to the record date when the company finalises the list of shareholders that will receive the next dividend payment. Accordingly, shareholders that sell shares on or after the ex-dividend date will still be entitled to receive the next dividend payment on the payment date, although the new owner will not. Usually, shares that trade immediately after the ex-dividend date will be accompanied by a decline in the share price that is equivalent to the amount of the next dividend payment.
(d) Record date;
Record date is the date on which the company determines the list of shareholders that will receive the next dividend payment. In Australia, the record date occurs 4 business days after the ex-dividend date.
(e) Payment date.
Payment date is the date on which the company actually makes the dividend payments to the shareholders on its record.
Does dividend policy affect the share price of a company?
There are two opposing viewpoints with respect to how dividend policy decisions affect the share price of a company:
Dividend Irrelevance Theory
Dividend Relevance Theory
Dividend Irrelevance Theory
Dividend Irrelevance Theory states that a company’s dividend policy is irrelevant and has no effect on the overall cost of capital nor the market value of the company. Specifically, Dividend Irrelevance Theory argues that the market value of a company is determined by the basic earning power and the business risk of the company. Therefore, the market value of a company depends only on the net income (or positive cashflows) produced by the company and not on how it splits its retained earnings between financing investments for future growth versus dividend payments to shareholders. As a result, Dividend Irrelevance Theory contends that investors are only concerned with the total returns they receive, and not whether they receive those returns in the form of dividends, capital gains or both.
Dividend Irrelevance Theory practical implication
Since Dividend Irrelevance Theory argues that shareholders are not concerned with a company’s dividend policy, this implies that company managers can set any dividend policy without affecting the company’s share price.
Dividend Relevance Theory
In contrast, Dividend Relevance Theory states that the market value of a company is affected by its dividend policy, with the optimal dividend policy being the one that maximises the market value of the company. Specifically, Dividend Relevance Theory contends that a company’s dividend policy can affect its market value due to investor preferences for either dividends (as ‘bird-in-hand’ theory contends) or capital gains (as ‘tax preference’ theory contends):
Bird-in-Hand’ Theory:
The ‘Bird-in-Hand’ Theory argues that, since current dividend payments are more certain
than future capital gains, investors would prefer to receive dividends today rather than
receive capital gains in the future.
Bird-in-Hand’ Theory: Practical implication
Since ‘Bird-in-Hand’ Theory argues that investors prefer to receive dividend payments
today rather than capital gains in the future, this implies that company managers ought to
set a high regular dividend payments policy so as to minimize the cost of equity and
maximize the company’s share price.
‘Tax Preference’ Theory:
On the other hand, the ‘Tax Preference’ Theory argues that, since dividends are taxed
immediately whereas capital gains are not taxed until the share is sold (with potentially
indefinite deferral of tax), investors would prefer to defer tax by receiving capital gains in
the future rather than receiving dividends today and being taxed immediately.
Tax preference theory Practical implication
Since ‘Tax Preference’ Theory argues that investors prefer to defer tax by receiving
capital gains in the future rather than receiving dividends today, this implies that company
managers should set a low regular dividend payments policy so as to minimise the cost of
equity and maximise the company’s share price.
types of
dividend policies:
(a) Residual dividend policy;
(b) Constant payout ratio dividend policy;
(c) Stable dollar dividend policy;
(d) Low regular dividend plus extras dividend policy.
(a) Residual dividend policy;
Residual dividend policy refers to a policy in which the company only makes dividend payments to shareholders when there is retained earnings left over after having financed all profitable investment opportunities. In other words, the residual dividend policy dictates that dividend payments to shareholders should only be paid out of leftover earnings.
(a) Residual dividend policy; implication
Although the residual dividend policy minimizes the cost of capital for the company by reducing the need to raise funds through the issuance of new equity or shares (which represents the most expensive form of financing), the residual dividend policy will necessarily result in the variation of dividend payments to shareholders due to fluctuations in both the amount of retained earnings and the cost of pursuing profitable investment opportunities over time. Since investors value economic certainty, this variation or instability of dividend payments sends conflicting signals to investors that might, in turn, adversely affect the company’s share price.
(b) Constant payout ratio dividend policy;
Constant payout ratio dividend policy refers to the policy in which the company distributes a fixed proportion of its earnings to shareholders in the form of dividend payments (for example, if the board of directors declare a constant payout ratio of 30%, then, for every dollar of earnings, 30 cents will be paid out to shareholders as dividends).
(b) Constant payout ratio dividend policy; implication
Although the dividend payout ratio remains constant over time, the dollar value of dividend payments will necessarily fluctuate as earnings change over time. Again, this fluctuation in dividend payments sends conflicting signals to investors that might, in turn, adversely affect the company’s share price.
(c) Stable dollar dividend policy;
Stable dollar dividend policy refers to the policy in which the company pays a fixed dollar amount of dividend payments to shareholders each year such that the annual dollar dividend is relatively predictable for investors.
